Cornell Law Review Volume 89 Article 2 Issue 3 March 2004 An Agency Costs Theory of Trust Law Robert Sitkoff Follow this and additional works at: http://scholarship.law.cornell.edu/clr Part of the Law Commons Recommended Citation Robert Sitkoff, An Agency Costs Theory of Trust Law, 89 Cornell L. Rev. 621 (2004) Available at: http://scholarship.law.cornell.edu/clr/vol89/iss3/2 This Article is brought to you for free and open access by the Journals at Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in Cornell Law Review by an authorized administrator of Scholarship@Cornell Law: A Digital Repository. For more information, please contact [email protected]. AN AGENCY COSTS THEORY OF TRUST LAW Robert H. Sitkofft This Article develops an agency costs theory of the law of private trusts, focusing chiefly on donative trusts. The agency costs approach offers fresh insights into recurringproblems in trust law including, among others, modi- fication and termination, settlor standing,fiduciary litigation, trust-invest- ment law and the duty of impartiality, trustee removal, the role of so-called trust protectors, and spendthrift trusts. The normative claim is that the law should minimize the agency costs inherent in locating managerial authority with the trustee and the residual claim with the beneficiaries, but only to the extent that doing so is consistent with the ex ante instructions of the settlor. Accordingly, the use of the private trust triggers a temporal agency problem (whether the trustee will remain loyal to the settlor's original wishes) in addi- tion to the usual agency problem that arises when risk-bearing and manage- ment are separated (whether the trustee/managerwill act in the best interests of the beneficiaries/residualclaimants). The positive claim is that, at least with respect to traditionaldoctrines, the law conforms to the suggested nor- mative approach. This Article draws on the economics of the principal-agent problem and the theory of the firm, and it engages the ongoing debate about whether trust law is closer to property law or contract law. Although the analysisfocuses on donative trusts, it should be amenable to extension in future work to commercial and charitable trusts. t Associate Professor of Law, Northwestern University. For helpful comments on ear- lier drafts, the author thanks Gregory Alexander, Jennifer Arlen, John Armour, Mark Ascher, Ronen Avraham, Lisa Bernstein, Richard Brooks, Brian Cheffins, Ronald Chester, Albert Choi, Barry Cushman, Kevin Davis, Simon Deakin, Deborah DeMott, Joel Dobris, Frank Easterbrook, David English, Lee Fennell, Mark Filip, Daniel Fischel, Tamar Frankel, Nicholas Georgakopoulos, Joshua Getzler, David Haddock, Philip Hamburger, Henry Hausmann, David Hayton, R.H. Helmholz, Adam Hirsch, Marcel Kahan, Louis Kaplow, Andrew Kopans, Reinier Kraakman, John Langbein, Melanie Leslie, James Lindgren, Paul Mahoney, Fred McChesney, John McGinnis, Thomas Merrill, Roger Myerson, Jeffrey Pen- nell, James Penner, Eric Posner, Richard Posner, Claire Priest, Eric Rasmusen, Larry Rib- stein, Roberta Romano, Jeffrey Schoenblum, Steven Schwarcz, Steven Shavell, Helene Shapo, Samuel Sitkoff, Tamara Sitkoff, Stewart Sterk, George Triantis, Thomas Ulen, Law- rence Waggoner, Sarah Worthington, Albert Yoon, and workshop participants at Cam- bridge, Chicago, Harvard, Indiana, London (London School of Economics and King's College), Michigan, Northwestern, Oxford, Virginia, and the Annual Meetings of the American (2003), Midwest (2002), and Canadian (2002) Law and Economics Associations. Richard Nolan fielded numerous questions about English law. The author also thanks Litsa Georgantopoulos, Kathryn Hensiak, Jeremy Polk, and Jeremy Sitkoff for excellent research assistance and the Victor Family Research Fund and the Northwestern University School of Law Summer Faculty Research Program for financial support. 621 CORNELL LAW REVIEW [Vol. 89:621 INTRODUCTION .................................................... 623 I. TRUST LAW AS ORGANIZATIONAL LAw .................... 627 A. Trust Law as Property Law .......................... 628 B. The Contractarian Challenge ....................... 629 C. Asset Partitioning and Organizational Law .......... 631 D. The Rise of the Managerial Trust ................... 633 II. ECONOMIC FOUNDATIONS .................................. 634 A. The Theory of the Firm ............................ 634 B. The Economics of Agency .......................... 636 C. Agency Costs and Organizational Forms ............ 637 III. THE AGENCY COSTS MODEL ................................ 638 A. The Contractarian Nexus ........................... 638 B. The Office of the Trustee .......................... 641 C. The Relative Position of the Settlor ................. 643 D. Beneficiaries as Residual Claimants ................. 646 IV. APPLICATIONS OF THE MODEL .............................. 648 A. Donative Beneficiaries as Residual Claimants ........ 649 1. The Duty of Impartiality .......................... 650 2. Total Return Investing ............................ 652 3. Risk Tolerance and the Duty of Care ............... 654 B. The Settlor-Beneficiary Tension ..................... 657 1. Modification and Termination..................... 658 2. Trustee Removal .................................. 663 3. Settlor Standing .................................. 666 4. Trust Protectors .................................. 670 C. Internal Governance and External Transactional A uthority ........................................... 671 1. Equitable Tracing ................................ 672 2. The Spendthrift Trust ............................. 674 D. Fiduciary Litigation ................................. 677 1. Litigation Incentives .............................. 679 2. Fiduciary Sub-Rules ............................... 682 C ONCLUSION ................................................... 683 2004] AN AGENCY COSTS THEORY OF TRUST LAW INTRODUCTION Agency cost theories of the firm dominate the modern literature of corporate law and economics.. Meanwhile, the private express trust, an entity from which the corporation traces its roots, 2 has been left largely untouched by agency cost analysis.3 Yet, in an echo of Adolph Berle and Gardiner Means's famous critique of the corpora- tion's "separation of ownership and control," 4 the central feature of the private trust is that it "separate [s] the benefits of ownership from the burdens of ownership." 5 This implies that many of the analytical tools supplied by the agency cost theories of the firm, which are rou- tinely applied in the economic analysis of corporate law, should be similarly applicable to the underdeveloped economic analysis of trust law.6 Indeed, problems of shirking and monitoring, the driving con- cerns of agency cost analysis, abound in trust administration. Accord- ingly, this Article develops an agency costs theory of trust law as organizational law, here focusing on donative private trusts. The anal- I See Michael C. Jensen & William H. Meckling, Theory of the Firm: ManagerialBehavior, Agency Costs and Ownership Structure,3J. FIN. ECON. 305 (1976); see also Armen A. Alchian & Harold Demsetz, Production,Information Costs, and Economic Organization,62 AM. ECON. REV. 777 (1972); Eugene F. Fama, Agency Problems and the Theory of the Firm, 88J. POL. ECON. 288 (1980); Eugene F. Fama & Michael C. Jensen, Agency Problems and Residual Claims, 26J.L. & ECON. 327 (1983) [hereinafter Fama & Jensen, Residual Claims]; Eugene F. Fama & Michael C. Jensen, Separation of Ownership and Control, 26J.L. & ECON. 301 (1983) [herein- after Fama & Jensen, Separation]; Symposium, Contractual Freedom in Corporate Law, 89 COLUM. L. REv. 1395-1774 (1989). See generally STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS § 1.5, at 26-38 (2002) (discussing various economic models of business organizations). For the classic exposition in the legal literature, see FRANK H. EASTER- BROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAw (1991). 2 See Edward Rock & Michael Wachter, Dangerous Liaisons: Corporate Law, Trust Law, and InterdoctrinalLegal Transplants,96 Nw. U. L. REV. 651, 655-57 (2002); Joseph T. Walsh, The FiduciaryFoundation of CorporateLaw, 27J. CORP. L. 333, 333-35 (2002); see also 3 FREDE- RIC W. MAITLAND, Trust and Corporation, in THE COLLECTED PAPERS OF FREDERIC WILLIAM MAITLAND 321, 395 (H.A.L. Fisher ed., 1911) (stating "that the connection between Trust and Corporation is very ancient"). 3 Prior systematic applications of agency cost analysis to trust law are scarce. The principal exception is A.I. Ogus, The Trust as Governance Structure, 36 U. TORONTO L.J. 186 (1986). This is not to say, however, that agency cost analysis has not occasionally informed specific analyses. See, e.g., AdamJ. Hirsch, Trusts for Purposes: Policy, Ambiguity, and Anomaly in the Uniform Laws, 26 FLA. ST. U. L. REV. 913, 928 (1999); Adam J. Hirsch & William KS. Wang, A Qualitative Theory of the Dead Hand, 68 IND. L.J. 1, 28-30 (1992);Jonathan R. Ma- cey, Private Trusts for the Provision of PrivateGoods, 37 EMORY LJ. 295, 315-21 (1988); Stewart E. Sterk, JurisdictionalCompetition To Abolish the Rule Against Perpetuities:R.IP. for the R.A.P., 24 CARDOZO L. REv. 2097, 2111-14 (2003). 4 ADOLPH A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRI- VATE PROPERTY 5 (1932). 5 1 AUSTIN WAKEMAN SCOTT & WILLIAM FRANKLIN FRATCHER, THE LAW OF TRUSTS § 1, at 2 (4th ed. 1987) [hereinafter ScoTr ON TRUSTS]. 6 See Henry Hansmann